Convertible Debt and Investment Timing∗

In this paper we provide an investment-based explanation for the popular-ity of convertible debt. Specifically, we demonstrate the ability of convertible debt to alleviate and potentially totally eliminate the underinvestment prob-lem of Myers (1977). The conversion feature induces shareholders to accelerate investment. This effect arises from the incentive of equity holders to acceler-ate the issuance of new equity, used to finance investment. By investing early, shareholders dilute the value of convertible debt holders by reducing their pro-portional claims to the firm’s cash flows. Since the underinvestment effect and the accelerated investment effect work in opposite directions, convertible debt allows, in many cases, to achieve the first-best investment strategy. In addi-tion, we show that by choosing a right combination of straight and convertible debt, shareholders can, for a wide range of overall debt levels, commit to the first-best investment strategy